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The picture brightens for international markets

March 2023

Amid the widespread financial turmoil of 2022, it was not hard to find reasons to be particularly cautious on international equities. In Europe, the war in Ukraine destabilized the region and threatened a potential energy crisis. In China, zero-COVID measures clamped down on the economy and squeezed supply chains; and in Japan, market returns were dampened by restrictions of foreign travelers and a sharp drop in the yen.


While there are still considerable risks that could affect international growth—the continuing war in Ukraine and potential for interest rate hikes among them—the picture on financial markets has of late shifted considerably. With worst-case scenarios likely already priced into asset levels, international markets could be set to outperform on a relative basis in 2023.


The shift in outlook has been most visible in Europe, where markets began to take on a more optimistic tone in the fourth quarter, with the MSCI Europe index rising a sharp 19% over the final three months of 2022.


“Overall, Europe had a massive move up in the fourth quarter with considerable multiple expansion,” says Mark Grammer, Managing Director and Head of International Equity at Gluskin Sheff.


Key to the strength in Europe has been the extremely cheap valuations that European stocks were trading for much of last year, exacerbated by the decline of the euro versus the U.S. dollar over the first nine months of the year. But the European market has also benefited from fortuitous weather, as the unexpectedly mild winter has helped allay fears of a heating crisis in the region.


“The weather Europe has experienced so far this winter has been a huge help. Natural gas storage has actually been moving up during the winter, rather than down,” said Grammer.


The specter of a European heating crisis emerged last year after sanctions were imposed against Russia following its invasion of Ukraine, cutting off the gas it typically supplies to the region and prompting a sharp rise in gas prices. But with temperatures having remained above average through most of the winter, gas inventory has remained high, which has allowed prices to fall below where they were before Russian invaded Ukraine last February.

This has both reduced concerns of a severe recession in Europe and has taken pressure off governments that had expected to have to spend for additional gas supplies.

“It’s had a materially positive impact on fiscal budgets of the European countries because they would have had to help subsidized businesses and consumers on the high energy prices,” said Grammer.


Despite the strong European rally off of 2022 lows, European equities as a group continue to trade at attractive price-to-earnings valuations. As of mid-February, European stocks traded at a 30% P/E discount to U.S. S&P500 stocks, which is below their 20-year average and considerably wider than their long-run 15% discount to U.S. stocks.


Another boost for Europe, as well as a reason for optimism in several Asian markets, has come from China’s surprise decision to rescind its restrictive zero-COVID policy in December of last year. The policy, which upheld travel restrictions and imposed snap lockdowns as a response to COVID outbreaks, kept a lid on China’s growth and trading activity, hurting market sentiment in the region.


The Chinese main equity index has been on a positive tilt since the country began easing restrictions in November. But the action has more far-reaching effects, as China’s massive economy has considerable influence on both its neighbour countries and on markets around the globe.


“Other markets in Asia, because of their exposure to China, benefited from zero-COVID ending,” said Grammer. “Another factor to bear in mind is European companies have higher exposure to Asia, and particularly China, than they do to the U.S., and that should be a positive for European companies.” China’s rebound from restrictions should also be helped by recent government fiscal stimulus and recent earnings upgrades for several Chinese companies.


One country that could benefit particularly from China’s reopening is Japan, which recently rescinded its own restrictive pandemic border controls.


“Japan’s inbound tourism from China was very strong prior to the pandemic, and it expects Chinese inbound tourism to recover substantially by the summer, which will be constructive for growth,” said Grammer, who noted that the Japanese TOPIX stock index currently trades at around 12x forward earnings, making it one of the most attractively priced markets of the large geographic economic blocks.


With this and other drivers, Japan currently leads consensus growth forecasts among developed markets with 1.2% expected economic growth in 2023. Despite this, the Japanese yen is currently trading just above its lowest levels in 25 years. In contrast to most other developed countries, Japan has kept its interest rates low, because it has not faced the inflationary pressures felt in North America or in Europe. The cheap yen provides another reason for optimism for Japan’s markets, as it makes Japanese-produced products more affordable to foreign buyers.


There could be a further benefit if the Bank of Japan (BoJ) begins to tighten its monetary policy later this year, which some expect to happen after current BoJ Governor Haruhiko Kuroda retires in April. Higher rates would likely attract dollar-denominated investors back to the Japanese market, which would increase returns for those already invested there.


There are of course, still geopolitical risks that could impact international markets, not the least of which is the continuing war in Ukraine. There is also the potential for more aggressive monetary tightening in Europe and Japan, which could contribute to near-term volatility in those markets.


North American markets also continue to show volatility, as the U.S. economy has shown itself to be resilient in the face of significant monetary policy tightening by the U.S. Federal Reserve. This resilience complicates the Fed’s efforts to curb inflation by slowing demand, and it’s likely that U.S. rates will move higher and remain there for at least the rest of the year, says Peter Zaltz, Chief Investment Officer at Gluskin Sheff.


“The resilience of high inflation is a problem for markets, meaning rates will stay higher for longer and they’re not even at their peak yet,” said Zaltz.


Gluskin Sheff’s International Equity strategy is heavily weighted towards Europe and Japan, with smaller allotments to Asia excluding Japan. The strategy is currently underweight the U.K., which has the worst growth outlook of the developed international market due to persistent inflation and the knock-on effects of Brexit.

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